Financial Decisions: Does Extreme Optimism Help?

New research from Duke University sheds light on the connection between optimism and money matters and being able to make prudent, or wise, financial decisions.

Duke University's Fuqua School of Business professors of finance, Manju Puri and David Robinson, wanted to study the connection, or relationship, between the personality trait of optimism and money matters to determine whether optimism effects prudence in relation to making financial decisions. They developed a unique method for defining optimism and used a unique source for collecting data on optimism.

The Federal Reserve Board conducts a triennial survey to determine U.S. families' financial and demographic standing and status through the Survey of Consumer Finance (SCF). The SCF collects data on demographics--age, ethnicity, education, income, investment and savings--and on health-related issues like the existence of chronic conditions or a family history of such. This is the same information that actuaries collect and use in determining aggregate life expectancy rates, as are pertinent to life insurance underwriting.

The SCF does not ask psychological questions nor personality questions that might be useful in determining optimism. However, it does ask for individual's own assessment of how long they expect to live.

Puri and Robinson used this self-assessment and the actuarial-related data to determine SCF respondents' levels of optimism. They identified two categories: optimists who believe they will live longer than the statistical actuarial data indicates and extreme optimists who are the top 5 percent of optimists and believe they will live 20 years longer than statistics indicate.

The correlations Puri and Robinson found between levels of optimism and financial prudence were striking and covered many significant aspects of routine and long-term money matters and financial decisions.

Optimists, as defined by the comparison between personal outlook and statistical data, tend to make wise money management, financial and long-term planning decisions. Some of the specific correlations between optimism and financial choices are that optimists work longer hours and save more money. Optimists make investments in individual stocks for growth or income and they planto defer retirement or not retire at all.

Additionally, optimists are more likely to keep up timely payments of their credit card balances and believe that their income will grow over the next five years. Further, if widowed or divorced, they are more likely to remarry.

On the other hand and in striking contrast, extreme optimists--the top 5 percent of optimists who believe they will live 20 years longer than actuarial figures indicate--work significantly less, which shows by their putting in significantly fewer hours at work. In correlation with this, extreme optimists save less money.

Further, extreme optimists are less likely to keep current with their credit card debt, while their stock investment portfolios tend to have a high proportion of day trades as opposed to long-term investments in individual stocks for growth or income. As well as being less likely to remarry should they be widowed or divorced, extreme optimists also, surprisingly, are more likely to smoke.

The researchers make a comparison between extreme optimism and over-confidence saying that, as the differences between the optimist and the extreme optimist are so remarkable, extreme optimism, "like over-confidence, may in fact lead to behaviors that are unwise," as Puri put it.

Puri's and Robinson's findings are of practical usefulness in that they can be employed by individuals to help them understand and ultimately overcome obstacles to sound money management and financial decisions. As the researchers say, the findings can help individuals who are overly optimistic overcome personality characteristics that prohibit them from making prudent financial decisions.

Robinson makes the final comparative comment that even though doctors advise drinking one or two glasses of red wine a day with a meal, no doctor advises drinking the whole bottle at one time. Robinson says: "It's the same with optimism. A little bit is really beneficial, but too much can lead to some really bad economic choices."

"The economic power -- and pitfalls -- of positive thinking," Duke University.